Investors with a risk appetite can consider an exposure in the Initial Public Offer (IPO) of DLF, one of the largest real-estate developers in India.
DLF's well-rounded businesses in the residential, commercial and retail space; the superior location of its land bank; and, more important, its management bandwidth and track record place the company among the top real-estate players in India.
In the offer price-band of Rs 500-550, the company is valued at a price-earnings multiple of 39-43 times the consolidated earnings for FY-07 on the current equity base.
Given the stiff pricing, the offer calls for at least a three-year investment perspective and an appetite for risk beyond what is traditionally associated with equity investments.
The aggressive growth plans outlined by the company pose a number of risks. One, the company does not own all the land on which it has planned its projects.
Two, there are doubts about whether the market can absorb high-end luxury residential projects on the massive scale planned by the company (particularly in Gurgaon).
Three, while the company has settled the discord with the minority shareholders on the debenture conversion issue, the imbroglio has dented somewhat its image in the eyes of shareholders on its crisis management skills.
Based on the net asset value of its existing land bank (another valuation method usually applied to realty companies), the offer appears fully priced. The net asset value calculates the discounted value per share net of liabilities, based on the income the company is likely to derive by converting its land bank into projects.
This method does not factor in the company's ability to replenish its land bank and the income potential from the same.
This does not also take into account potential revenue from the company's plans in the hotel, infrastructure and Special Economic Zone segments or agreements it entered into recently to acquire other landparcels .
On DLF and the offer
DLF enjoys a strong brand positioning across residential, commercial and retail segments. It plans to venture into infrastructure projects, hotels and SEZs and has entered into joint ventures with international players for the same.
The company has developed 224 million square feet of land and has 574 million sq ft of developable area, slightly higher than its peer Unitech's 472 million sq ft.
DLF plans to raise Rs 8,750-9,600 crore through this IPO. It plans to use Rs 3,500 crore for acquisition of land and development rights and a similar amount on on-going projects.
The rest would be used to repay a part of its debt. Post-issue, the company's market capitalisation is likely to be about Rs 90,000 crore at the offer price.
Key positives
DLF has stated in its offer document that its land bank of 10,255 acres is likely to last 10 years.
If the company is able to settle the balance due on its land bank (Rs 4,395 crore as of April 30), this would effectively help the company lock into land costs for projects over the next 10 years, thus cushioning against any price inflation.
This also implies that the company has a good 10-year window to replenish its land bank; it can time its acquisitions over different market phases. We consider this as a major positive for DLF, as it is important for developers to demonstrate the sustainability of their business by replenishing the raw material — land — at a good price and time.
Operations: A comparison
Going by DLF's size and scale of operations, Unitech may be the only comparable player in the listed space. A comparison between the two is interesting:
DLF's land bank diversification across 31 cities is a positive. It has land in Tier-I and Tier-II cities, providing better visibility and realisation to its projects.
As much as 51 per cent of DLF's land bank is in the National Capital Region against Unitech's 19 per cent.
Further, it has higher visibility in metro cities, than Unitech. DLF's presence in prime locations in New Delhi and Mumbai (NTC mill land) also suggests the high quality of its land bank.
We believe that this would aid the company command higher realisations than competitors.
Further, DLF's strategy of taking an aggressive stance in familiar territory, while being cautious in moving to new regions, appears a less risky way of foraying into new regions. Unitech, which has land in 16 cities, is more aggressive in less familiar territories.
DLF has aggressive plans for residential projects, especially in Gurgaon. While we do see risks from the company's exposure to that market, some of the ongoing projects give comfort.
About 85 per cent of the projects under construction is in the commercial and retail space. Industry reports suggest that demand in these segments is likely to remain strong in the medium-term, especially in the NCR.
In the light of the above, the prospects for the ongoing projects appear encouraging. It has also managed to rent out 97 per cent of the commercial space it has built so far. As for the residential segment, the company undertakes massive projects but in phases.
This allows the company to modify its plans, depending on market condition. We believe this could give the company leeway to move to the middle and upper-middle consumer group, were it to see saturation in the high-end residential business. A shift from plotted developments to townships and high-end apartments could provide acceleration to the operating profit margin over the long-term.
DLF has realised the need to augment its resources and execution capabilities for its ambitious plans, and has been striking joint ventures with strategic partners. For instance, the tie-up with international players such as WSP and Laing O'Rourke would enable DLF outsource a chunk of the design and construction activity. Similarly, partnering with players such as Nakheel Developers is likely to provide superior know-how. These may provide a cushion against execution risks.
DLF has also tied up with the Hilton group for managing hotels in India and identified 22 locations for the same. Further, in-principle approvals for 26,100 acres of SEZs and tenders for infrastructure projects are businesses in the offing.
Though the revenue streams have not been factored into our calculations, success in these areas could make DLF one of the most diversified plays in real-estate and infrastructure.
Further, the sheer size of operations should give the company the advantage of economies of scale, right from raw material sourcing to higher utilisation of assets.
This is evidenced by DLF's OPM growing from 27 per cent in 2005 to 57 per cent in 2007 (on sustainable earnings).
The contentious areas
Both sales and profit numbers for FY-07 have benefited from the sale of certain commercial property to DLF Assets Private Ltd, a promoter-owned company.
Two debatable issues arise from this transaction.
One, whether such income would be one-time and, two, if the sale to DLF Assets was done on competitive basis.
On the first issue, DLF's offer document states that it follows a build and sale/lease model and would execute such transactions in future too.
We believe that cashing in on some of the assets built, when the company sees value in such unlocking of cash, is an acceptable strategy to generate operational cash flows.
On the issue of the transaction involving a group company, DLF has stated that it has followed a competitive bidding process and would do so in future too.
DLF Assets had paid 65 per cent of the consideration to DLF as on the date of the red herring prospectus and this has, subsequently, been fully settled.
DLF does not own all of its 10,255-acre land bank. While it has title to 11.3 per cent of the bank, a good 35 per cent is still under `agreement to purchase'. The more important aspect is that the company has sole development rights to about 45 per cent of the land.
This entitles it to develop the land and enjoy substantial revenuesfrom such development for a fixed consideration.
While this agreement lacks clarity, such transactions owe their origin to the various urban land ceiling laws that were/ are in force in many regions.
DLF's history of success in dealing with such arrangements, however, inspires some confidence.
Highly geared
DLF has traditionally been a highly geared company. Post-issue and after utilising a part of the issue proceeds to repay loans, the debt-equity ratio should be about 1.5:1.
The company may, however, go back to the high gearing levels, given its major plans. This may not be a major concern as long as the company maintains its now comfortable interest coverage ratio.
We are, however, concerned about the high proportion of floating rate interest loans (75 per cent now), which could pose serious concerns in a scenario of hardening interest rates.
Macro factors such as a softening of real-estate prices (given the correction seen in certain markets) and the possible drying up of demand as a result of higher borrowing costs are factors that may pose a threat to the absorption of DLF's residential projects.
The offer is open from June 11 to 14.